Looking Back: Regulations and Financial Crises

I think the article Regulation and the Mortgage Crisis is worth mentioning. According to the author, it aims “to provide perspective” on the “finger-pointing about responsibility for the absence of effective regulation that would have stopped or moderated the crisis.” It’s a really interesting read.

There are two sectors where more extensive regulation might have made a difference [in preventing the current crisis]. These are the investment banks and the Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac. Both sectors were major players in the events leading up to the crisis.

In 2004 the SEC adopted a rule that pretty much allowed the investment banks to regulate themselves. While a number of other factors were involved in this decision, the commission’s belief at that time was that self-regulation would be more effective than SEC regulation. This policy was consistent with the free market ideology of the Republican administration.

In 2003, efforts to bring the GSEs under tighter regulatory control were defeated in Congress. This was primarily the work of Democrats, who feared that tighter regulation would crimp the ability of the GSEs to meet affordable housing goals.

The author refers to the decisions of Rebuplicans and Democrats which ultimately helped set the stage for this crisis “a tie” as far as political blame is concerned. He also hastens to add that “an only slightly less severe” crisis would have occurred anyway for reasons below.

Deregulation – defined as the removal of existing regulations – was not a factor in this crisis. The article explains that the only significant financial deregulation legislated in the past three decades applied to commercial banks. “Restrictions on where they could branch, and on their involvement in investment banking, were both removed. Most economists, including me, believe that these actions made the banks stronger than they would have been otherwise.”

The author then goes into an interesting historical explanation which explains that regulation itself is a weak defense to financial crises because regulations always tend to look backwards. For example, regulations on the Savings and Loans in the 1970’s were very strict – but the regulatory system was geared to preventing S&Ls from taking on too much default risk because, historically, that had always been the major problem. The exposure of S&Ls to interest rate risk was not controlled, which led to the huge financial crisis that many of us remember in the 1980’s.

S&Ls were encouraged to make long term fixed rate mortgages and loans with short term deposits. When interest rates spiked in the 80s the cost of deposits jumped, but revenue from loans stayed the same. Enter S&L crisis.

The policy changes that were introduced following the S&L crisis were largely designed to prevent another crisis of that type. Among other things, associations were authorized (and encouraged) to write adjustable-rate mortgages (ARMs) on which rates would adjust with the market. This would make S&Ls as well as banks less vulnerable to swings in market rates. Enter current crisis.

In short, regulations always have unintended (and usually unforseen) consequences which can sometimes cause problems just as bad ans the crisis they are designed to prevent. I’m sure Congress will shortly enact all sorts of regulations that will prevent a similar crisis to the one we’ve got now from ever happening again. I just hope whatever other consequences they inadvertently cause down the line aren’t too destructive…

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5 thoughts on “Looking Back: Regulations and Financial Crises”

  1. If you’re a lawyer or computer programmer, the problem of regulations is very simple. You’ve got what amounts to an expert system of legal regulations that act like “production rules”.

    Clever financial engineering can game the rules to find ways to profit with no risk (by passing the risk to the government, etc). Given that there’s tons of money to be made by such engineering, and they’ll always be one step ahead of the regulators (who are far more poorly paid civil-service types), it’s nearly impossible to avoid these. And the more regulation, the more of these are possible.

    This is what happened with S&L’s in the late 1980s: you could buy an S&L, make loans to yourself (or something controlled by you) to drain its cash, default on them, and have the government bail out the depositers. This essentially gave these guys an ATM machine connected to the public treasury.

    This sort of thing can happen without regulation as well, but since regulation tends to favor economies of scale (keeping up with a complex web of regulation favors large players over small ones), you get bigger messes with regulatory failure than you do with simple failure in relatively unregulated markets that have other rule badness.

  2. Frannie was a part of it, but never the majority of it. Their market share of subprime declined from 50% in 2002 when it was less than 1% of the market, to about 25% in 2006 when it peaked at 30% of the market.

    It wasn’t deregulation, but nonregulation; foregoing the administrative authority that already existed. Extending causes into the infinite past may deflect blame but transparent to the electorate as this election will show.

    Regulation forms a part of institutional memory. The regulations from the 30s eliminated the broker/dealer problems that occurred then and also occurred this time in Britain.

  3. “Deregulation – defined as the removal of existing regulations – was not a factor in this crisis. ”
    Doesn’t the author considers the 2004 decision to exempt 5 major investment firms from leveraging limits “deregulation”? Wasn’t SEC decision that allowed Lehman Brothers, Merill Lynch, Bear Stearns, Goldman Sacks and Morgan Stanley to be leveraged over 30 to 1 and use the money to buy Mortgage-Backed securities one of the major factors in this mess. BTW – at the time a lone software consultant wrote to them that their risk models for mortgage-backed securities are faulty and wouldn’t work in times of large market fluctuations, and his letter was ignored. It’s not a coincidence that 3 of these 5 firms are no longer with us and that it was the fall of Lehman that precipitated the crisis.

    Then there are smaller issues like the removal of uptick rule on short sales that allowed naked shorts to run amok and beat down companies’ stock to nothing. This is probably a small factor although it didn’t help Lehman, but it still was one of the examples of Cox’ stupidity.

    Of course, from regulation side you have mark-to-market rule which with respect to mortgage-backed securities lead to extra write-downs and further drop in value of this securities. Only about 5% of mortgages fail overall, so if banks could simply keep these securities to maturity and collect interest on mortgages that worked while writing down mortgages that failed they would have much smaller losses. Instead, with mark-to-market the banks had to write-down the drop in paper (resale) value of these securities that required them to put more cash in reserve, which dropped the resale value of these securities even further – way below what they would bring in terms of interest if they could just be held to maturity. Sure mark-to-market is a good rule sometimes, but in case of mortgage-backed securities it contributed to the crisis.

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